Interest Rate Hedging Strategies for Real Estate Debt

Find out the insights on interest rate hedging strategies for real estate debt from the leading professionals at the CREFC seminar. Explore to prevent economic uncertainties with the right decisions on time.

Learn all the key insights into interest rate hedging strategies for real estate debt revealed by the experts at this CREFC Europe seminar.

On Tuesday, 21st November 2023, CREFC Europe in partnership with Cambridge Finance and Real Estate Women presented a seminar on ‘Interest Rate Hedging Strategies in Real Estate Transactions’ hosted by Ashurst UK in their London offices. The seminar featured industry experts:

Alison Lambert, Head of Finance and Listed Markets at M7 Real Estate
Amy Crick, Head of London, UK Real Estate Teams at Barclays Corporate Bank, PLC
Jackie Bowie, Managing Partner and Head of EMEA at Chatham Financial
Maria Wiedner, Founder and CEO at Cambridge Finance and Real Estate Women Below is a summary of the key points discussed.

Introduction: The Sudden End Of Low Rates And Trussonomics

Stuart Blacklock, Partner in Real Estate Finance at Ashurst, set the stage for the seminar, highlighting the relevance of interest rate hedging in the current economic climate, particularly with the sudden end of a period of low-interest rates and the brief experiment with Trussonomics in the UK.

“Following the relatively sudden end of a period of low-interest rates, it’s hard to imagine a time when interest rate hedging is more topical… So I’m sure today’s session will bring us all a lot of food for thought particularly as we move into a period of what should be heightened market activity in interest rate hedging mechanisms.”

Presentation By Jackie Bowie: Hedging Strategies For Real Estate

Jackie Bowie gave us an insightful presentation on the various aspects of the cost of debt for real estate in the UK and interest rate hedging:

Inﬂation Trends and the Impact on Interest Rates:

The shift in perception of inﬂation from transitory to more persistent.

“Back in December 2021, Central Banks were seeing inﬂation as transitory. But in Q1 2022 it became obvious that inﬂation was not transitory and the supply side constraints in the market were causing inﬂation and that was feeding through into all aspects of the economy in the US, the UK, and Europe, and that is when the forward curve started the move upwards, pricing in the expectation that interest rates were going to rise.”

Historical Context:

The importance of understanding historical contexts in making hedging decisions – what the new ‘normal’ will look like.

“In the UK, if you’ve been in your career, say for just over 10 years, you probably think that ‘normal’ interest rates is half a percent or seventy-ﬁve basis points. So, your historical context makes a big difference in how you make hedging decisions. I have been having interesting conversations around assumptions going into the models because my deﬁnition of normal is probably between 4.75 to 5.25%.”

Interest Rate Caps:

The dynamics of interest rate caps, including premium costs and market volatility impact.

“In a cap, there is a strike rate set so that the borrower will pay ﬂoating until the cap strike is triggered and then the cap will pay you back the diﬀerence between the ﬂoating rate and the cap strike, creating a maximum rate of interest. And as such, the cost of interest rate is ‘capped’. It is an option product where the premium is related to the underlying forward rate – say three or ﬁve years – but also the implied volatility in the market. And there have been times in the last six to eight months when even though rates were coming down borrowers were expecting the cost of their caps to come down. But in fact, the cost of their caps was going up because the implied volatility was higher. People couldn’t understand why the cap premiums were more expensive when rates are lower than they were last week.”

Debt Cost Management Strategies:

The shift towards a combination of swaps and caps in hedging strategies is driven by the high cost of upfront premiums for caps and the benefits of ﬁxed rate swaps in managing the cost of debt.

“More combinations of swaps and caps are being deployed. And again, that’s because the cost of the upfront premium for the cap became so prohibitively expensive. Consequently, we’re starting to look at ﬁxed rate swaps as an alternative because there is no cash-out day one; unless you’re looking to try to reduce the coupon or subsidise your future rate.

Yield Curve Inversion:

The implications of the inversion in the yield curve for hedging decisions.

“You might have an upcoming reﬁnancing deadline, or you might have a new transaction where you want to lock in the market rate today because the model works for you on today’s interest rates. So you can hedge through options swaps, or combinations of these instruments. They don’t come without other complications, such as initial premium payments or future cash payments. But certainly, people have become very aware that the hedging market is moving very quickly and if there’s an opportunity to prepare for the future, they should do so. This inversion in the yield curve is creating some opportunities, which means that the further out in terms of the term you go the lower the rate becomes. Lots of people are asking themselves: how can I take advantage of that? And this is the discussion we will have ahead on the panel.”

Panel Discussion:

From left to right, Jackie Bowie, Alison Lambert, Maria Wiedner, Amy Crick and Stuart Blacklock

Changes in Hedging Strategies

Following Jackie Bowie’s insightful presentation, Maria Wiedner went on to open the discussion with the panelists and first asked Amy Crick her view on how borrowers and lenders were dealing with their hedging strategies.

Amy elaborated on the shift in hedging strategies in light of higher interest rates, explaining how borrowers are now more definitive about their hedging strategies. She highlighted that there are a variety of projects being deployed, overall reﬂecting a move towards simpler, more vanilla solutions than had been seen previously.

“I would say that we’ve moved away from perhaps some of the complexity that we saw in previous cycles and what we have now is more vanilla hedging structures and a higher volume of ﬁxed rate loans. According to the Bayes’ Commercial Real Estate Lending Report1, the overall proportion of UK CRE loans that remain ﬂoating is 25.4%, somewhat higher than where previous CRE Lending surveys have reported volume of outstanding loans hedged with an interest rate swap or set at ﬁxed interest (which peaked in 2016 at 89%). As a result, we are seeing more demand from borrowers who are choosing to mitigate the variability in their cost of debt and we expect the proportion of CRE ﬂoating rate loans to reduce.”

Discussion on Hedging from a Borrower’s Perspective

Maria Wiedner asked about the importance of managing cash flow and risk from a borrower’s perspective, particularly in the context of interest rate ﬂuctuations and the need for strategic hedging decisions. To which, it was noted:

“Some borrowers would prefer to swap out the loan to a ﬁxed rate because then they can manage our cash ﬂow knowing that the cost of debt is certain, and would have a stable cash ﬂow. So, from a borrower’s perspective, the decision to hedge is essential in knowing whether they can pay our shareholders and the pension funds.”

Insights on the UK Real Estate Market’s State and Hedging Preparedness

Maria Wiedner asked the panel about the unexpected rise in interest rates and its impact, especially on borrowers who might not have adequately hedged.

There was a discussion about the likelihood of distressed asset sales, creating opportunities for investors. Amy Crick commented:

“We are observing a period of readjustment requiring an amendment to interest cover covenants to reﬂect the higher rates environment. In some situations, borrowers will be utilising cash to reduce outstanding loans and interest costs. Additionally, we’ve noticed several borrowers preparing to capitalize on potential opportunities they anticipate arising. This includes quick moves around asset acquisitions that could positively contribute to their overall portfolio dynamics and be accretive to interest cover ratios. Various tools are in play here. This situation underscores the importance of relationship banking. It’s crucial to thoroughly understand the medium to long-term strategies of these borrowers.”

Broader Economic and Political Landscape’s Inﬂuence on Hedging

Maria Wiedner asked about how the broader economic and political landscape in the UK may affect decisions on hedging a borrower’s exposure to ﬂoating rates. To which Jackie Bowie’s comments were:

“Predicting future trends is challenging. Many here, understandably, are hoping for a quicker decrease in rates, especially when considering new borrowing arrangements. Currently, with the uncertainty surrounding interest rate movements, borrowers face a dilemma: whether to swap out at rates around 4.5 to 5%, knowing they might drop lower during the loan’s term. This decision involves potentially paying a premium over the ﬂoating rate for the loan’s duration but it gives a good amount of certainty. Such dilemmas lead to intriguing discussions about the length of hedging instruments, especially for loans extending around ﬁve years.”

Advice on Approaching Hedging Decisions

Maria Wiedner commented that the whole geopolitical situation has impacted inﬂation through the energy market and that this situation is not over yet; however, the forward curve is indicating a lower interest rate environment going forward. She then went on to ask what the most appropriate hedging decisions in the current market would be.

The panel is generally inclined towards focusing on certainty and cash ﬂow over trying to predict market movements.

Jackie Bowie’s Comments Were:

“When it comes to speculative approaches, it depends on your investors and their expectations. Don’t try to outsmart the market curve; it’s a tough battle to win. Focus more on certainty and managing cash ﬂow rather than trying to predict market movements.”

Emphasis was placed on aligning hedging decisions with the specific cash ﬂow and risk profiles of real estate assets.

Amy Crick’s Comments Were:

“A borrower’s Interest rate hedging strategy will be discussed and agreed upon at the point of negotiation of terms of the loan. For example, hedging 75% of the notional amount for the tenor of the loan. Lately, we’re engaging in more discussions with clients interested in exceeding a lender’s minimum requirements. This trend is driven by their focus on adhering to interest cover covenants, ensuring that they remain compliant throughout the loan. However, lenders and borrowers will also be mindful of protecting the reﬁnance position at the end of the tenor of the current loan/hedging.”

“In the past decade’s low-interest rate environment, caps were a common choice for borrowers needing to hedge. They would usually opt for the most aﬀordable interest rate cap to meet their lender’s requirements. However, we’re witnessing a shift from this practice as the strategy of hedging becomes a pivotal factor in managing the overall cost of debt.”

“Furthermore, the UK debt market is now more diverse than it was during the last ﬁnancial crisis with more direct investors and debt funds playing active roles – there is a degree of conﬁdence that the debt markets are better structured, with a healthier variety of debt providers to deal with any reﬁnancing gap that may arise.”

In summary, the panel discussion at the Hedging Strategies Seminar presented a multifaceted view of hedging in real estate finance, highlighting the need for strategic, informed, and adaptable approaches in a dynamic economic and political environment. The insights reﬂected a balance of perspectives from both lenders and borrowers, underscoring the complexities and nuances in implementing eﬀective hedging strategies.

About CREFC Europe

CREFC Europe is a trade association for the European real estate finance market. It organises industry events, working groups, and opportunities for information exchange and networking, and conducts advocacy work on behalf of its members, to promote well-functioning, responsible, and sustainable real estate finance markets that are appropriately transparent and liquid. Find out more at https://www.crefceurope.org/.

About Cambridge Finance

Cambridge Finance is a leading provider of real estate financial modelling courses, bespoke training, and consulting.

CEO and founder Maria Wiedner has trained delegates across jurisdictions in 37 countries since the company’s founding in 2016, also drawing upon a network of expert trainers, academics, and practitioners. The company’s expertise encompasses all real estate areas: office, retail, hotels, industrial, residential, PBSA, healthcare, mixed-use, and shopping centres; listed and non-listed funds; development and income-producing assets.

Cambridge Finance is an RICS-regulated firm for investment advice and financial modelling consulting. Maria Wiedner is a leading figure in discounted cash ﬂow methods whose figures and work underpinned the RICS’s Discounted Cash Flow global practice guidance published on 15th November.

About Real Estate Women

Real Estate Women (REWomen) is a global network of real estate professionals committed to creating an equitable, inclusive, and resilient built environment. Founded in 2012 by CEO Maria Wiedner, REWomen’s strength lies in the diversity of its network, which includes investment professionals, fund managers, lawyers, accountants, academics, architects, planners, communication specialists, recruiters, surveyors, civil engineers, lenders, agents, and other real estate professionals. Based in the UK, REWomen has a global reach through collaborative partnerships with international companies and organisations.